Thursday, November 1, 2012

Fiscal cliff uncertainty remains high; likely a drag on growth in the US

DB ran some analysis on the public's shifting concerns using Google Trends (see discussion). What they found is that as the Eurozone fears recede (for now), the uncertainty about the US fiscal cliff (see discussion) remains.

DB: - This rise in concern about the fiscal cliff in the U.S. has
coincided with a decline in concern about euro risk ..., due in large part to the ECB’s bond buying
program. ... The
frequency of news articles about Europe has plunged since
early October as that of articles about the cliff has
remained elevated. ... a more conventional
indicator of euro risk – the spread between the average
yield on Spanish and Italian 10-year bonds and 10-year
German bonds – has declined substantially since the
announcement of the ECB’s bond buying program,
consistent with the decline in the frequency of the term
“Europe” in our U.S. news article search.

Source: DB

The question however is whether anyone should really care about uncertainty. Is there evidence that uncertainty such as the one related to the fiscal cliff will have a negative impact on the economy - a hotly debated topic particularly in an election year. DB argues that the effect is significant. They looked at the relationship between the BBD Uncertainty Index (news-based) and economic indicators - hiring and manufacturing orders - as well as the impact on equity prices and rates.

DB: - The negative relationship
between uncertainty and private hires and manufacturing
orders no doubt helps to explain the weakness in both of
these measures in recent months.
...
Our analysis suggests that the rise in economic policy
uncertainty has significantly impeded the U.S. recovery
from the financial crisis. In fact, a rise in economic policy
uncertainty similar to that observed since the financial crisis
reduces the S&P 500 by about 8%, 10-year Treasury yields
by nearly 50bps, and manufacturing orders by
approximately $10bn – about 2% of average monthly
orders.

Some readers will be skeptical of such an assessment (as they should be), particularly given potential political implications. After all, the current administration has been accused of not fully addressing the uncertainty associated with the fiscal cliff and regulation, thus, according to the above analysis, impeding economic growth.

It seems however that other research has been fairly consistent with these results. The attached paper from Baker Bloom & Davis, the authors of the BBD index, have similar findings (paper contains some interesting data on uncertainty indices that are based on non-financial data such as news). Here is what they concluded:

BBD: - Using Cholesky orderings to construct orthogonal [uncorrelated] shocks, we find
that a policy uncertainty shock equal in size to actual increase in the index value from
2006 to 2011 foreshadows drops in private investment of 16 percent within 3 quarters,
industrial production drops of 4 percent after 16 months, and aggregate employment
reductions of 2.3 million within two years. These findings reinforce concerns that policy related
uncertainty played a role in the slow growth and fitful recovery of recent years,
and they invite further research into the effects of policy-related uncertainty on economic
performance.

Just as the policy uncertainty played havoc on the Eurozone's economy (ultimately putting it into a recession), the uncertainty around tax policy, budget cuts, and regulation are likely inhibiting economic growth in the US.

For the record, this is not a criticism of the current administration, but simply an observation. Whether policy uncertainty under a different administration would have been lower is a topic for another discussion (comments welcome as always).